The Big Idea

Trading the consumer balance sheet

Steven Abrahams | January 26, 2024

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

For households and companies alike, ability to repay debt—and the fair value of that debt—usually reflects assets and income. Or, to put a finer point on it, on net worth and income. You borrow against net worth to refinance debt or cover extraordinary expenses. And you use income to service debt. By those measures, households today look surprisingly strong despite nearly two years and 525 bp of monetary tightening. That is true even at lower tiers of income. And that is bullish for consumer credit, even at tighter-than-average spreads.

Household balance sheets today show a number of strengths:

Net worth now tops pre-Covid marks across income tiers
Broad gains in leverageable real estate have fueled the rising net worth
Real disposable income has moved above its long-term trend, and
Consumer delinquencies still show no clear signs of distress

That does not mean every household or consumer is on Easy Street. But strong net worth and income argue that diversified household and consumer credit exposures, all else equal, should trade at tighter spreads than they did for long stretches before Covid.

Net worth tops pre-Covid marks across income tiers

Average household net worth today in both absolute terms and as a multiple of GDP is higher than historic averages and, perhaps more relevant, higher than pre-Covid marks. The average household from the start of 2020 through last July gained $38.4 trillion in net worth. And scaled against GDP, the average household went from have $4.79 free and clear for every $1 of GDP to having $5.16 free and clear (Exhibit 1). The multiple has varied as stocks have rallied and sold off in recent years. But the net rally in stocks since July should push both absolute net worth and the multiple of GDP even higher.

Exhibit 1: Household net worth now tops pre-Covid marks

Note: Quarterly data, not seasonally adjusted.
Source: Federal Reserve, Santander US Capital Markets

The improving net worth is not just a story of have and have not. Absolute net worth jumped across all tiers of income, with lower and middle tiers rising by equal or larger percentages than higher tiers. The top 1% of earners since the start of 2020 have added $5.9 trillion in net worth, for example, with the bottom 20% adding $1.1 trillion (Exhibit 2A). But while top earners have improved net worth by 22%, the bottom 20% of earners has improved by 34%. Other middle-income tiers have improved net worth by 42% (Exhibit 2B).

Exhibit 2A: Absolute net worth tops pre-Covid across income tiers

Source: Federal Reserve, Santander US Capital Markets

Exhibit 2B: Net worth has improved fastest in lower income tiers

Source: Federal Reserve as of 3Q2023, Santander US Capital Markets

Improvements across household assets

Rising asset values have driven the gain in net worth. From the start of 2020 through 2022, household assets rose 22.5% with liabilities up only 20.2%. Improvements came in almost every major category (Exhibit 3). The price of real estate, the largest and most widely held household asset, went up. Public and private equity gained. The Milliman Pension Funding Index showed pensions emerging from a decade of underfunding to become fully funded starting in 2022 and continuing through 2023. And as my colleague Stephen Stanley has long noted, households also built up a sizable supply of liquid cash, bank deposits and money market funds.

Exhibit 3: Composition of US household assets as of September 2023

Source: Federal Reserve, Santander US Capital Markets

Improvement across income tiers in the most leverageable asset: real estate

The improvement in the value of household real estate is especially notable since real estate is arguably the most efficient asset for households to borrow against and create a buffer against unemployment or other economic shocks. Households with equity have the wherewithal to borrow from a wide range of lenders at competitive rates and with tax advantages. Home equity rose $12.6 trillion from the start of 2020 through last July, equivalent to 6.1% of the value of the real estate (Exhibit 4). Households now have nearly 72% of the value of their real estate in leverageable equity—reflecting the high percentage of homes owned outright—and the rest in mortgage debt.

Exhibit 4: Households continued to gain real estate equity

Source: Federal Reserve, Santander US Capital Markets

As with net worth, the rise in home equity has come across all tiers of income although by different amounts. From the start of 2020 through September, the top 1% of earners picked up $1.7 trillion in home equity, for instance, while the bottom 20% picked up $612 billion (Exhibit 5).

Exhibit 5: Home equity rose across income tiers

Source: Federal Reserve, Santander US Capital Markets

Rising home equity probably matters more for lower income tiers because it is a higher share of total net worth. As of September, home equity constituted 43% of the net worth of the bottom 20% of earners, for example, and only 15% of net worth for the top 1% of earners (Exhibit 6).

Exhibit 6: Home equity is a larger share of net worth for lower income households

Source: Federal Reserve as of 3Q2023, Santander US Capital Markets

At this point, the market has recognized that the low cost of existing fixed-rate debt for most homeowners and the high cost of new debt has discouraged housing turnover and reduced the supply of existing homes for sale to the lowest level in at least 20 years. Extraordinarily low supply has helped keep home prices rising, and they should continue rising in most scenarios. Freddie Mac forecasts home prices will rise this year by 2.7%, and Fannie Mae by 2.8%. Rising home prices should further add to household net worth.

Real disposable income rises above trend

Beyond rising net worth, a labor market with unemployment at or below 4% for two years has pushed real consumer income above trend. Despite inflation in recent years running at some of the highest levels in four decades, average income has kept up. Since the early 1980s, real income per capita has moved up an average of $157 a quarter. That pace accelerated sharply in spring 2020 and winter 2021 with a wide range of government transfers to households. But even as those programs have lapsed, real income since last July has moved up at an average of $414 a quarter, leaving it today just above trend (Exhibit 7).

Exhibit 7: Real income per capital lately has moved above trend

Source: Federal Reserve as of 2Q2023, Santander US Capital Markets

Improving real income, relatively low interest rates on mortgage and other debt taken out in 2020 and 2021 and a limited debt load has helped household ability to service that debt. The cost of debt and other financial obligations—such taxes, insurance, rent or auto leases—is still less than 15% of disposable personal income as of last July, the most recent numbers available from the Fed, and below pre-Covid or most levels since the Global Financial Crisis (Exhibit 8). And the cost of debt only is less than 10% of disposable personal income and also below pre-Covid and most post-GFC levels.

Exhibit 8: Consumer ability to cover debt service and other obligations is steady

Source: Federal Reserve as of 2Q2023, Santander US Capital Markets

No signs of distress from consumer delinquencies

With improving net worth and good real income, it is probably no surprise that aggregate consumer delinquencies fall at or below most levels of the last few decades (Exhibit 9). Delinquencies of 90 days or more on auto loans, for example, are at the 54th percentile of the last 20 years. Delinquencies of 30 days or more on securitized credit card balances are at the 15th percentile. Delinquencies of 30 days or more on mortgages are at the 5th percentile. And delinquencies on student loans of 90 days or more, after a long payment holiday during Covid, are at the 2nd percentile. All of these delinquency rates are below the levels at the start of 2020. The aggregate numbers show no signs of stress.

Exhibit 9: Most consumer delinquencies have trended down since 2020

Source: Bloomberg, Santander US Capital Markets

Despite no clear signs of distress in aggregate delinquencies, reports from the New York Fed do show delinquencies in subprime and near-prime auto and card debt moving well above pre-Covid levels. And some credit card lenders, such as Discover Financial Services and others, have reported rising charge offs in recent quarters. Those delinquencies and charge offs could signal that weaker tiers of consumers are starting to get in trouble.

But recent work by the staff at the Federal Reserve Board raises questions about those delinquency rates. The Fed work looks at the elevated delinquencies through the lens of consumer credit scores, which have migrated higher through pandemic. The Fed research suggests that upward credit score migration sharply reduced the total outstanding amount of debt held by subprime borrowers—reducing the total amount faster than the amount rolling delinquent and consequently inflating the delinquency rate.

To be concrete, imagine 1,000 consumers before pandemic where 230 had subprime credit scores, roughly the subprime share the Fed study shows. Assume 28 consumers go delinquent on their auto loans, again roughly the delinquency rate the Fed shows for late 2019. By the third quarter of last year, assume rising credit scores left only 180 subprime consumers, also consistent with the Fed numbers. If the number of delinquencies did not decline at the same rate—presumably because credit scores did not rise on the delinquent accounts—then the delinquency rate for the subprime population would rise.

When the Fed researchers correct for score migration by holding borrowers’ scores constant at their value for the last quarter of 2019—equivalent to looking at a fixed pool of borrowers, just like an investor might look at a single quarter vintage of subprime securitizations—subprime delinquencies actually look lower than pre-pandemic (Exhibit 10). The work clearly argues that the cohort of borrowers that qualified as subprime pre-Covid are showing lower auto and card delinquency rates today.

Exhibit 10A: Auto loan DQ rates using current and 4Q19 credit scores

Exhibit 10B: Credit card DQ rates using current and 4Q19 credit scores

Note: Delinquency is at least 30 days past due, excluding severely derogatory loans. Prime refers to credit scores above 719, near prime between 620 and 719, and subprime below 620. Credit scores are lagged four quarters. Dashed line shows delinquency rates holding credit score distribution fixed as of 2019:Q4.
Source: Federal Reserve Bank of New York Consumer Credit Panel/Equifax and Driscoll et al (2024), The Effects of Credit Score Migration on Subprime Auto Loan and Credit Card Delinquencies, FEDS Notes.

Consumer credit should trade tighter than usual

The aggregate strength of net worth and income do not mean all households and consumers are immune to routine delinquency or to economic shock. Delinquencies should rise if growth slows, but likely less than they have in past similar slowdowns. Some of the weakest consumer balance sheets also could easily get hurt by idiosyncratic shocks of unemployment or even local home price decline. But that is an argument for holding broad, diversified exposures rather than the idiosyncratic risk of a narrow set of names.

The current above-average strength of household net worth and income argue that diversified consumer credit exposures, all else equal, should trade at tighter spreads than where similar exposures traded for long stretches of time pre-Covid. Household are better equipped to absorb shocks to assets or income. Lower fundamental risk on the US household balance sheet argues for tighter spreads.

Investors have a wide range of exposures to choose from that directly or indirectly reflect current relatively strong household and consumer credit risk. A partial list:

Prime and subprime credit cards
Prime and subprime auto loans and leases
Unsecured consumer loans
Agency credit risk transfers
Agency specified pass-through pools
Agency MBS IO or inverse IO
Non-agency MBS mezzanine and subordinate classes
Single-family rental debt and equity
Mortgage loans
Home equity loans
Debt of US homebuilders

The distinct return goals and risk tolerances of different portfolios may argue more for one of these exposures than for others. And not all these exposures offer the same relative value. But analysis of possible suitability and relative value will have to wait until next week.

* * *

The view in rates

Another week and fed funds futures continue to price for 125 bp of cuts by December, 50 bp more than the Fed’s median dot. The market-implied chance of a cut in March remains just below 50%. If Powell & Co. do not counter market pricing strongly at the FOMC on January 31, then investors will likely assume the Fed agrees with pricing and reprice for faster and deeper cuts. And the yield curve will likely bull steepen. In either case, counter or no counter, implied rate volatility is highly likely to drop after the January FOMC.

Other key market levels:

Fed RRP balances closed Friday at $571 billion, down $55 billion week-over-week and continuing a steady trend down since April. Treasury bills and Treasury and MBS repo all trade at yields above the RRP’s 5.30% rate. Money market funds continue to move cash out of the RRP and into these higher-yielding alternatives.
Setting on 3-month term SOFR traded Friday at 532 bp, unchanged week-over-week but broadly lower since September.
Further out the curve, the 2-year note closed Friday near 4.35%, 3 bp1lower on the week. The 10-year note closed at 4.13%, unchanged on the week.
The Treasury yield curve closed Friday afternoon with 2s10s at -26, steeper by 5 bp In the last week. The 5s30s closed Friday at 33 bp, steeper by 4 bp over the same period.
Breakeven 10-year inflation traded Friday at 229 bp, lower by 5 bp over the last week. The 10-year real rate finished the week at 185 bp, up 6 bp in the last week.

The view in spreads

The market continues to tighten spreads in credit, anticipating an eventual Fed rate cut and improvement in market liquidity. If the FOMC does not push back on January 31, spreads in risk assets should tighten further. One caveat: liquidity is nevertheless likely to trend lower through 2024 as QT and relatively high rates in the front end of the curve continue. Lower liquidity is likely to keep volatility elevated, keeping pressure on spreads, leaving them a tad wider than otherwise. Nevertheless, spreads should trade stable to tighter until at least March.

The Bloomberg US investment grade corporate bond index OAS closed lately at 93 bp, tighter by 2 bp over the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 142 bp, tighter by 4 bp in the last week. Par 30-year MBS TOAS closed Friday at 41 bp, roughly unchanged over the last week. Both nominal and option-adjusted spreads on MBS look rich. Fair value in MBS is likely closer to 70 bp, so a widening toward 70 bp looks reasonable.

The view in credit

Most investment grade corporate and most consumer sheets look relatively well protected against higher interest rates, and eventual Fed easing should relieve pressure from interest rate expense and falling liquidity. Fixed-rate funding has large blunted the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. Consumer balance sheets also benefit from record levels of home equity and steady gains in real income. Consumer delinquencies also show no clear signs of stress. Less than 7% of investment grade debt matures in the next year, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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